LPC: US CLOs may see record year as investors seek interest-rate hedge

NEW YORK, Jan 10 (Reuters) - The US Collateralized Loan Obligation (CLO) market may be heading for a record year in 2018 as investors seek floating-rate assets as a hedge to rising interest rates.

More than US$117bn of US CLOs was raised in 2017, the second-largest year of issuance ever, on the back of increased investor appetite. With expectations for similar economic conditions this year, banks are optimistic for 2018 including Wells Fargo which is predicting a record US$125bn in issuance.

Rising interest rates may push investors toward products that thrive in a rising-rate environment, including leveraged loans and CLOs, which pay investors a coupon plus the London interbank offered rate (Libor). JP Morgan in November said it is expecting four rate hikes in 2018.

“Higher front end rates should generally be supportive for loans and CLOs,” Brad Rogoff, head of credit strategy at Barclays, said in an email.

Initial concerns that regulations requiring managers to hold onto a portion of their fund’s risk would temper issuance – original 2017 US CLO forecasts were just US$50bn-US$70bn – were shrugged off as firms raised new money to comply with the rule. This fundraising aimed at supporting multiple CLOs over the course of a few years opened the market to new investors, helping to buttress volume.

“The retention dynamic has helped open [the market] to a lot more people than just CLO diehards,” said Tom Majewski, founder of Eagle Point Credit Management, which invests in the equity and junior debt of CLOs.

The Dodd-Frank Act risk-retention rule that took effect December 24, 2016, requires managers to hold 5% of their funds. While questions about the regulation’s application persisted throughout 2017, firms were able to develop plans and raise funds to comply.

“Many managers went to investors that were willing to open programmatic investing in the asset class through risk retention rather than investors that look on a deal by deal basis,” said John Wright, head of Bain Capital Credit’s CLO/structured products business. “This increased both the number and the types of investors, and that has created a lot of demand for CLOs.”

CHANGING THE RULES

The rule as the market knows it may soon be a thing of the past as President Donald Trump vows to dismantle Dodd-Frank. The Treasury Department in October recommended that a qualified risk-retention exemption for CLOs be introduced.

The uncertainty around the continuation of regulations has slowed retention fundraising, Majewski said.

Managers this year are also expected to continue reworking existing deals after a record US$164.8bn of US CLOs were refinanced or reset in 2017, according to Thomson Reuters LPC Collateral data. Bank of America Merrill Lynch analysts predict US$100bn of refinancing and reset activity in 2018.

In a refinancing, the spreads paid to the most senior investors, the Triple A holders, are cut, increasing payouts to equity holders who are paid last with the interest left over after all debtholders receive their distributions. A reset extends the maturity of a CLO allowing it to stay in place longer.

Triple A spreads on new deals are also expected to continue to tighten with Bank of America Merrill Lynch forecasting they could drop to 90bp-95bp. A handful of funds issued in the final two months of last year paid investors 107bp after the first US CLO of 2017 priced its most senior tranche at 145bp, according to LPC Collateral data.

A limiting factor to strong issuance this year may be a lack of new collateral in the loan market, according to Laila Kollmorgen, a managing director in leveraged finance at PineBridge Investments.

A record US$923.8bn of US institutional loans was arranged in 2017, but US$503.2bn of that debt was the refinancing of existing loans, according to LPC data.

To counter a lack of new credit and the lower coupons from those refinancings, firms may consider buying high-yield bonds for their funds, which pay higher spreads that may help boost returns. CLO managers had largely stopped purchasing that type of debt following the release of the Volcker Rule, which prohibits banks from investing in CLOs that owns bonds.

“We may get some further issuance of CLOs that are non-Volcker compliant because of the desire by CLO managers to issue but are finding it difficult to access loan collateral,” Kollmorgen said. (Reporting by Kristen Haunss; Editing by Jon Methven)